The financial lives of shareholders and their closely-held corporations are often intertwined. As a result, itís not usual to find loans between these corporations and their shareholders. This letter focuses on the up-front planning necessary to optimize the tax results for such loans.

Advantages of Making Loans to Your C Corporation

If your investment in a successful C corporation is entirely characterized as equity (stock), it will be difficult to withdraw any of your stake without some or all of the withdrawal being treated as a dividend. (This is normally not a problem with S corporations because funds can generally be taken out tax-free to the extent of stock basis.) Dividends from a C corporation are bad news because they are taxable to you, but your corporation cannot deduct the payments.

In effect, dividends are subject to double taxation. Your corporation pays income taxes on the earnings that generate the dividends, then you have to pay income taxes too when the earnings are paid out to you. That may not sound fair, but unfortunately thatís the way the tax rules work.

In contrast, when part of your investment is in the form of a shareholder loan to your C corporation, you gain the following tax advantages:

You can collect the loan principal repayments tax-free. Thus, you can recover part of your investment in the corporation without triggering any taxes.

The interest payments to you are deductible by your corporation. This allows you to withdraw additional cash from your corporation without double taxation.

If the loan goes bad, you may be able to claim a business bad debt loss, which can offset your income from other sources (salary, self-employment income, capital gains, interest, dividends, etc.). Generally, a business bad debt loss can be claimed if you habitually make business loans, or if your primary reason for making the loan was to protect your salary as a corporate employee. However, if the main reason for the loan was to protect your investment in the corporation, a subsequent bad debt loss is treated as a short-term capital loss. Short-term capital losses are still valuable because they offset your capital gains for the year. If your loss exceeds your capital gains, you can normally write off up to $3,000 against income from other sources. Any leftover short-term capital loss is carried over to the following tax year.

To lock in all these nice tax breaks, you want to ensure that the IRS will treat your arrangement as a loan rather than as disguised equity. Here are the guidelines to follow.

You should receive a written promissory note from the corporation stating that the company is making an unconditional promise to repay a sum certain on demand, at a fixed maturity date, or in installments on specified dates.

Preferably, the interest rate should be at least equal to the applicable federal rate or AFR. (More on that later.)

Your corporation should not be "thinly capitalized." If it is, the IRS may attempt to recharacterize purported corporate debt as disguised equity. Then you are back into the double-taxed dividend scenario. Thin capitalization is a potential problem whenever the corporationís ratio of debt to equity is considered excessive for the industry. Itís difficult to generalize about when a corporation will cross the thin capitalization line. However, the issue should be addressed whenever any new debt will cause the debt to equity ratio to exceed about 3:1. We are available to consult with you on whether or not your corporation is affected by thin capitalization concerns.

At the time the loan is made, a corporationís financial condition should indicate it is capable of repaying the loan according to the terms of the promissory note. Also, adequate collateral should exist.

The corporate minutes should reflect that taking on the debt was authorized by corporate officers and should include a summary of the loan terms (interest rate, repayment schedule, collateral, etc.).

Your corporationís financial statements and your personal financial records should reflect a loan between you and the corporation. Ditto for any financial statements given to lenders or issued to third parties for regulatory or credit rating purposes.

Avoid convertible debt instruments. Why? Because debt that can be converted into stock has historically been looked upon less favorably by the IRS than debt with no conversion feature.

Perhaps most important of all, the interest and principal payments should be made on time. If scheduled payments are missed, the promissory note should be amended to reschedule them. When payment deadlines go by with "no comment" from the lender and no collection activity against the borrower, the IRS can make a much stronger case that the purported debt was actually disguised equity. Hello, double taxation!

Loans from Your Corporation to You

Itís quite common for a closely held C corporation to advance funds to a shareholder with little or no thought about the tax consequences. Although the transaction may be intended as a loan, documentation is often lacking.

Once again, this opens the door for the IRS to claim that the payment to the shareholder was actually a disguised dividend rather than a loan. If the IRS is successful, double taxation will result. How do you avoid this distasteful tax outcome? Easy. Just follow the earlier guidelines about loans from you to your corporation. The advice is equally relevant for loans going the other way.

Even if the transaction is clearly a loan, there can still be unfavorable tax consequences under the below-market interest rules when too little (or no) interest is charged.

However, you need not worry about the below-market interest rules if the aggregate outstanding balance of loans from the corporation to you is $10,000 or less. If you qualify for this loophole, your corporation can charge very low interest or zero interest with no harm done.

You also need not worry about the below-market interest rules if your corporation charges an interest rate at least equal to the applicable federal rate (AFR). Basically, the AFR is the minimum that can be charged without creating unwanted tax "side effects." The IRS publishes AFRs monthly in the Internal Revenue Bulletin. The relevant AFR for a particular loan is the one in effect for loans of that duration for the month the loan is made. For example, say your corporation loaned you $20,000 in June of 2000. The AFR for a short-term loan made that month (term up to 3 years) was 6.35% with monthly compounding, the AFR was 6.42% for mid-term loans (more than 3 and up to 9 years), and it was 6.21% for long-term loans (over 9 years). Once the AFR is determined, it continues to apply over the life of the loanóregardless of how interest rates may fluctuate during that time. The exception is demand loans, for which the AFR is redetermined annually by "blending" the monthly short-term AFRs for that year.

As you can see, the AFRs are much lower than the rates charged by commercial lenders. However, as long as your corporation charges you at least the AFR, you wonít have to worry about any of the tax complications explained below. Your company will have taxable interest income equal to the stated interest rate, and you will have an equal amount of interest expense (which may or may not be deductible, depending on how the loan proceeds are used).

When the below-market interest rules do applyósay because your corporation loans you over $10,000 at zero interestóthe tax laws say you must calculate "imputed" (imaginary) payments between you and the company. The imputed payments are calculated using the difference between the AFR interest rate and the interest rate actually charged, if any. Basically, the corporation is treated as transferring imputed payments to you. These payments are considered either taxable compensation (which is acceptable) or a taxable dividend (which is bad). Then you are treated as transferring the imputed amount back to the corporation as interest (which you may or may not be able to deduct, depending on how you use the borrowed funds).

To avoid the dreaded dividend scenario, your corporationís minutes should specify that any imputed payments from the corporation to you under the below-market interest rules are to be considered employee compensation. Of course, this presumes you are a bona fide employee and that your total compensation is reasonable. With this strategy, your corporation gets a compensation deduction for the imputed payment to you. That write-off offsets the companyís imputed interest payment from you.

Conclusion

As you can see, there are plenty of things to think about when arranging a corporation-shareholder loan. With careful planning, the IRS can usually be kept at bay. On the other hand, poorly documented loan transactions will almost certainly open up a can of worms if either you or the corporation gets audited. Please give us a call if you have questions or want more information.